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Brazil Bonds Yield Less Than Default Swaps on `Huge' Demand: Brazil Credit
Record investment in Brazilian bonds is driving the yield premium on the securities to the lowest since April relative to the country’s credit-default swaps.
All-time-low borrowing costs in the U.S. and Europe led investors to put $3.8 billion in Brazilian bond funds this year in search of higher returns, reversing a $131 million net withdrawal in the year-earlier period, according to EPFR Global, a research firm in Cambridge, Massachusetts. Some investors are unable to trade in the swaps market, prompting them to buy the country’s bonds and causing the decline in yields relative to the default swaps, according to HSBC Global Asset Management.
“In the global search for yields, there has been a huge inflow into emerging-market fixed income assets,” Peter Marber, the New York-based head of developing-nation debt and currencies at HSBC Global, which oversees more than $400 billion worldwide, said in a telephone interview. “There’s been a record amount of fund inflows from long-only investors that want to own cash bonds as opposed to derivatives, such as CDS. It could be a new normal as long as interest rates globally remain low.”
The extra yield investors demand to hold Brazilian five- year dollar bonds instead of U.S. rates fell to 107 basis points, or 1.07 percentage points, yesterday, according to data compiled by Bloomberg. The difference, known as the Z-spread, was 11 basis points below the country’s five-year credit-default swaps, near the most in four months. That’s a reversal of the three-year average in which the default swaps were six basis points lower than the Z-spread.
‘New Normal’
Default swaps are usually lower than bond spreads because they are more actively traded and require less cash to invest in. Demand for cash assets is reducing the “liquidity premium” in bonds over swaps, according to Aaron Grehan, who helps oversee $2 billion in emerging-market funds at Aviva Investors in London. Brazil’s bond spreads jumped to a record 88 basis points over the default swaps in December 2008 when the global financial crisis eroded demand for emerging-market debt.
While the current gap may be a signal that the bonds are overvalued, the indicator likely reflects growing investor confidence in Brazil and other emerging markets, according to Grehan. Brazil’s budget deficit equals 3.4 percent of gross domestic product, or about one third the U.S. gap. The largest economy in Latin America will grow 7.1 percent this year, the fastest pace in more than two decades, according to a central bank survey of analysts released yesterday.
“Are we overvalued, or are we in a new era where emerging markets, including Brazil, can come of age?” Grehan said in a telephone interview. “That’s a big question. At absolute levels, these bonds do look stretched. But if this is a new normal, it is relevant. Lots of flows are coming in and you cannot underestimate it.”
Colombia, Mexico
The difference between credit-default swaps and the bond spreads also is inverting in Colombia and Mexico as investors search for higher-yielding debt amid a plunge in U.S. and European rates. Two-year U.S. Treasury notes yield touched an all-time low of 0.45 percent today, while 10-year German bunds reached an unprecedented 2.15 percent this week amid speculation the global economic expansion is slowing.
“We are simply in an unusually low interest rate environment, and that to me what is ultimately driving this phenomenon,” said Marber.
Developing-nation bond funds attracted $32.3 billion this year through Aug. 18, triple the previous full-year record set in 2005, according to EPFR Global. The $3.8 billion that Brazilian bond funds attracted in the first seven months of the year tops the previous full-year record of $2.1 billion set last year, according to EPFR. Brazil’s credit rating was raised to Baa3, the lowest investment grade, by Moody’s Investors Service last year, matching the BBB- rating from Standard & Poor’s and Fitch Ratings.
Faster Growth
The average yield on Brazilian dollar bonds over U.S. Treasuries narrowed 39 basis points in the past three months to 202, compared with the record low of 138 set in June 2007, according to JPMorgan Chase & Co.’s EMBI+ index. The average overall yield on the bonds has declined 89 basis points over that time to 4.94 percent.
“The spread will continue to get tighter as we will continue to see low interest rates globally,” Vivienne Taberer, a portfolio manager who helps oversee about $70 billion at Investec Asset Management in Cape Town, South Africa, said in a telephone interview. “Money is still searching for yields. My sense is things will become more expensive.” Taberer said she cannot “rule out” that the EMBI+ spread for Brazil will drop below the all-time low as the economy grows faster than developed nations.
Trading Increase
Trading in Brazil’s bonds increased to $37.1 billion in the second quarter, the most among emerging markets, from $30 billion in the first three months this year, ING Groep NV said Aug. 13, citing a survey conducted by New York-based Emerging Markets Trade Association. Trading in Brazil’s credit swaps declined to $69.4 billion from $74.4 billion.
Credit-default swaps pay the buyer face value in exchange for the underlying securities or cash equivalent should a borrower fail to meet its debt agreements. A basis point is 0.01 percentage point, and is equivalent to $1,000 a year on a swap protecting $10 million of debt for five years.
Yields on the interest-rate futures contract due in January held at 10.68 percent today, indicating traders expect the central bank to hold its benchmark to 10.75 percent by year-end.
The real was little changed at 1.7701 per dollar.
Brazil’s dollar bonds returned 13.6 percent this year, compared with the average gain of 14.1 percent among emerging markets, according to JPMorgan. U.S. Treasuries returned 8.1 percent this year, including reinvested interest, after losing 3.7 percent in 2009, Bank of America Merrill Lynch index data show.
“There’s a lot of money going into emerging-market funds in general, and it has to go somewhere,” Alberto Boquin, Latin America debt and currency strategist at Bank of America Corp. in New York, said in a telephone interview. “You can’t fight the flow of money going” to emerging-market funds, he said.
To contact the reporters on this story: Ye Xie in New York at yxie6@bloomberg.net; Veronica Navarro Espinosa in New York at vespinosa@bloomberg.net
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